Monday, Apr. 23, 2012
By Ruchir Sharma
Foreign tourists stand and chat on a busy street at the Paharganj market in New Delhi on April 9, 2012
Manan Vatsyayana / AFP / Getty Images
It's been a long time since the farmers left the "farmhouses" of Delhi, but the word now describes the weekend retreats of the upper class, playgrounds on the fringes of this emerging-market city where unmapped dirt lanes wind through poor villages and suddenly open onto lavish mansions with sprawling gardens and outsize water features.
On a foggy night in late 2010, I made my way to a party at one such fabulous home, where the valets were juggling black Bentleys and red Porsches and the hosts invited me to try the Kobe beef they had flown in from Japan, the white truffles from Italy. Over the pulsating techno music, I managed to chat with a 20-something son of the farmhouse demimonde. He was a classic of the type — working for Dad's export business, wearing a tight black shirt, hair spiky with gel. After determining that I was a New York — based investor back in town looking for opportunities, he shrugged. "Well, of course. Where else will the money go?"
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I left the party around midnight, well before the main course was served, but the comment stayed with me. It summed up the overconfidence in the big emerging markets after a decade of unprecedented success. Only 10 years earlier, emerging markets were seen as the problem children of the financial world, and some pitchmen were trying to rechristen them the "e-merging" markets, hoping to steal some shine from the tech boom in Silicon Valley. These developing nations were spoofed as an inversion of the 80/20 rule, which states that 80% of your profit comes from the top 20% of your clients. Until recently, emerging markets accounted for 80% of the world's population but only 20% of economic output. As recently as 2002, the big-money investors avoided emerging markets as too small or too dangerous. For many, India was the Wild East.
Since then, private-capital flows into developing countries have surged, rising from $200 billion in 2000 to just under $1 trillion at their peak in 2010. Though the totals have ebbed a bit, they remain at historically high levels. Even now, best-selling books argue that with the West in decline, the money is bound to flow east and south. Everyone is thinking big about the coming convergence, when average incomes in all poor nations will supposedly catch up to those in rich ones.
The idea that everyone can win in the global growth game was built on the unique results of one unusual decade. Starting in 2003, a run of unbroken growth that began in China spread across the globe. By 2007, the average GDP growth rate in emerging markets had doubled — from 3.6% in the previous two decades to 7.2% — and almost no developing nation was left behind. That year all but three of the world's 183 national economies grew, and 114 grew by 5% or more, up from an average of just 50 per year in the previous two decades. The only losers were Fiji, Zimbabwe and the Republic of the Congo, basket cases that seemed to prove the optimistic rule. This was the fastest, most all-encompassing growth spurt the world had ever seen — and it came with no downside. Inflation was well in check planetwide. Many observers came to the conclusion that the emerging nations were all Chinas, destined for decades of rapid growth.
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That's not likely. Economic development is like a game of snakes and ladders: nations are much more likely to get bitten and fall back than to keep climbing. My research shows that over the course of any given decade since 1950, on average only one-third of emerging markets have been able to grow at an annual rate of 5% or more. Fewer than one-fourth have kept up that pace for two decades, and only one-tenth for three decades. Just six markets — Malaysia, Singapore, South Korea, Taiwan, Thailand and Hong Kong — have maintained this rate of growth for four decades, and only two, South Korea and Taiwan, have done so for five decades. Few front runners stay in the lead for a decade, much less many decades. Identifying those few is an art rather than a science of extrapolation.
Yet analysts are still looking for the past decade's miracle of mass convergence to continue all over the globe. It has become fashionable to cite the forecasts of pundits and historians who look back to the 17th century, when China and India accounted for about half the world economy, as evidence that these nations will re-emerge as dominant powers by 2030 or 2050. The reasoning seems to be that 17th century performance offers some guarantee of future results. The old rule of forecasting was to make as many forecasts as possible and publicize the ones you got right. The new rule is to forecast so far into the future that no one will know you got it wrong.
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In the practical world, no one bases plans on forecasts that go out more than five to 10 years. And for the past half-century, the early years of each decade began with a global mania for some new change agent that had emerged in the previous decade. In 1970 the mania was for top U.S. companies like Disney, followed by gold and oil in 1980, Japan in 1990 and Silicon Valley in 2000. In all these booms, pundits offered exotic reasons to believe that the mania would last, only to see the bubble pop early in the new decade.
The big emerging markets have, of course, been the mania of our day, the conventional wisdom being that they have become, after their debt crises of the 1990s, responsible, high-growth creditors. Yet many have missed the main driver of the boom: easy money. It was no coincidence that the emerging markets began to levitate in mid-2003 after aggressive U.S. interest-rate cuts — aimed at sustaining a recovery after the tech bubble burst — started a worldwide flood of money as many central banks raced to match the Fed rates. This was a unique golden age, unlikely to be repeated yet widely accepted as the new standard. Now the credit house of cards has collapsed, a casualty of the Great Recession. The liquidity-fueled, turbocharged boom of the past decade is unraveling as the cost of funding growth rises. Once a financial soufflĂ© collapses, it can rise again only after memories of the collapse fade. Given the depths of the recession of 2008, however, another debt binge is extremely unlikely in the next decade.
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The New New Normal
There is much talk in the west of a "new normal," defined by slower growth as the big economies struggle to pay down huge debts. What observers had not realized, at least until recent weeks, is that emerging markets also face a new normal. As growth slows in rich nations, they will buy less from countries with export-driven economies, such as Mexico, Taiwan and Malaysia. During the boom, the average current balance in emerging markets nearly tripled as a share of GDP, inspiring a new round of hype about the benefits of globalization, but since 2008 the current-account surplus has fallen back to the old share of under 2%. Export-driven emerging markets, which is to say most of them, will have to find a new way to grow at a strong pace.
The new era will be defined by moderate growth, the return of the boom-bust business cycle and a breakup of herd behavior. The growth rate in emerging markets will slow to about 5%, its average in the 1950s and '60s — a period when expansions were punctuated by recessions and the race to catch up with the West was in its usual state of churn. The contours of the coming slowdown have been visible for some time, and now the headline evidence is upon us: The growth rate in Russia has fallen to 4% from its boom highs of 8%. India has announced in the past month that its growth is slipping from about 8.5% to under 7%. And Brazil admitted that its growth fell from around 4% to just 2.7% in 2011. In China, which had grown at better than 8% for 14 years, Premier Wen Jiabao lowered the official target to 7.5% at the National People's Congress in March, and for a change, the risk is that growth will fall short of the target. This is a fundamental shift in the dynamics driving the rise of poor nations. As growth in the developing world slows from the breakneck 7% pace of the 2003 — 07 boom years to 5%, the rising tide will no longer lift all boats.
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In this slower and more volatile world, the growth rates of countries and companies will start to diverge. A nuanced perspective may not have mattered so much even a decade ago, when developing economies represented less than 20% of the global economy and 5% of stock-market capitalization. As of 2011, emerging markets account for nearly 40% of the global economy and just under 15% of global market cap. These economies are now too big to be lumped into one marginal class and are better understood as individual nations.
Within this huge pool of competitors, only a few nations will defy the long odds against success. Those are the breakout nations, by which I mean those that can sustain rapid growth, beating or at least matching high expectations and the average growth rates of their income class. For a nation like the Czech Republic, in the per-capita-income class of $20,000 and above, breaking out will mean 3% to 4% growth in GDP, while for India, in the income class of $5,000 and below, anything less than 6% to 7% growth will feel like a recession. It is harder to grow from a rich base, so it makes no sense to compare the challenges of richer emerging markets like Taiwan (average income $20,000) to those of poorer markets like the Philippines ($2,500). Breaking out is all about beating market expectations for your income class.
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And as countries hit the middle-income mark, this will get a lot tougher. This is true of all the BRICS — Brazil, Russia, India, China and South Africa — countries but in particular China, which has grown faster than 8% for so long that slowing to 6% to 7% will be felt as a mild recession and could destroy hundreds of billions invested in China plays. After adjustments for changes in the exchange rate, China is at roughly the same income level — about $5,000 — as Japan in the early 1970s, Taiwan in the late 1980s and South Korea in the early 1990s. Though they all continued to catch up to the U.S., they did so much more slowly, with growth rates falling from about 9% to 5% for many years.
Of course, in economic life, happiness is a function not of what you have but what you have relative to others. The prospect of living among rapidly prospering neighbors, even if the pace of growth will slow somewhat, is so unsettling that it has distorted Western views of emerging markets. In early 2011, Gallup asked Americans to identify the world's leading economy; 52% said China, and 32% said the U.S. — an astonishing misperception. China's economy is still a third the size of the U.S.'s. As George Orwell once observed, "Whoever is winning at the moment will always seem to be invincible." But over the next decade, China's image will shrink back to realistic dimensions. The angst generated by a 1-percentage-point slowdown in growth in the West will pale in comparison with that accompanying a 3-to-4-point slowdown in China. The big story will be that China is too large and too middle-aged to grow so fast.
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The uneven rise of the emerging nations will reshape the global balance of power, dimming the glow of recent stars like Brazil and Russia and lessening the apparent threat from petro-dictators in Africa, the Middle East and Latin America. Restoring balance to American self-perceptions will reduce the pressure on Washington to raise new trade barriers and to cast China as a growing threat. Western fears of the BRICS countries' forming a political bloc will fade as their clashing interests come to the fore. The core group of Brazil, Russia, India, China and South Africa includes commodity exporters as well as importers, and while China has rapidly growing trade and financial links with the other four, those four don't do much business with one another. They will be hard pressed to find a common program for growth in a slowing world economy.
Big ideas popularized during the boom — like convergence — will fade. Because China's boom was driven by a large generation of young people entering the workforce, there is now a cottage industry of consultants who use population trends to forecast the next economic miracles. In India, fear of a population bomb led to a mass sterilization campaign in the 1970s, but it has since given way to celebration of population growth as a demographic dividend. These forecasts assume that government can give young people the skills to find jobs in a rough global market, one that's only going to get tougher for emerging markets.
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It's likely to get easier for the U.S. The currencies of many major emerging markets are rising against the dollar, producing an American manufacturing revival. After falling by a third since 2001, by mid-2011 the dollar was at its cheapest inflation-adjusted rate since the early 1970s. The U.S. share of global exports, which had long been declining, bottomed out at 8% in 2008 and is now inching higher. Basic American strengths — including rapid innovation, a relatively young population for a rich nation and openness to immigration — are stirring a comeback in the nation's energy industry; the U.S. recently overtook Russia as the top producer of natural gas. They are also extending the U.S. lead in technology; all the hot new things, from social networking to cloud computing, seem to be emerging once again from Silicon Valley or rising hot spots like Austin. The same reversal is possible in parts of Europe, especially Germany, the only rich nation that has lost none of its manufacturing base to emerging-market competition.
Most important, the idea that emerging markets will take over the world will cease to be the dominant bubble story of our day. Not all emerging markets will be breakout nations, and their paths will vary significantly. Investors and companies that are betting big on all emerging markets' rising together as a homogeneous class have to start treating them as individual stories. No nation can hope to grow as a free rider on the tailwinds of fortuitous global circumstance, as so many have in the past decade. They will have to propel their own weight, and the breakout nations of the new era will take their mantra from a Latin proverb: "If there is no wind, row."
Sharma is head of emerging markets and global macro at Morgan Stanley. This essay is adapted from his new book, Breakout Nations: In Pursuit of the Next Economic Miracles
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